Let’s be honest: most of us feel at least a bit uneasy when it comes to understanding our taxes. Whether you file online, drop paper forms in the mail or trust a CPA to handle everything for you, there are a few things that you should learn first.
While Uncle Sam is more than happy to take his fair share of your income, taxpayers are offered a number of lucrative breaks in the form of tax credits and tax deductions. But what exactly is the difference between the two and which one can save you the most on your IRS bill?
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How Deductions and Credits Are Similar
At the end of the day, both tax deductions and tax credits offer a way for Americans to reduce their overall tax burden. This means that either one–or a combination of the two–can be used to lower someone’s IRS bill. The result is either a larger deduction on the amount owed or an increased tax return after filing.
Both tax deductions and tax credits are claimed when filing taxes each spring. Both also have certain requirements that you must meet in order to claim them, and/or different values based on your filing status.
While both can save you money, there are many more differences than similarities.
The Difference Between Tax Deductions and Tax Credits
So, what exactly are the differences between these two and which one is better for your bank account?
In a nutshell, tax deductions are intended to reduce your taxable income. Your taxable income is the number from which your federal tax burden is calculated, so you’ll really be saving a percentage of that deduction on your tax bill.
Let’s see a (seriously oversimplified) calculation to show how this works.
Say you are in the 22% marginal tax rate with $75,000 in taxable income. After applying a $5,000 deduction, your taxable income drops to $70,000. Since you stay within the same marginal tax bracket, that $5,000 deduction effectively saves you about $1,100.
On the other hand, a tax credit is a dollar-for-dollar reduction of your tax burden. Owe $5,100 in federal taxes this year but have a $650 tax credit? You now owe only $4,450, keeping every penny of that $650 in your pocket.
In some cases, tax credits can even result in a tax refund or increase a refund you’re already expecting.
Common Tax Deductions
Everyone’s individual tax situation will be different. However, there are a few common tax deductions that many filers can take advantage of to lower their IRS tax burden.
Across the board, the most helpful is probably the standard deduction. With the standard deduction, you can reduce your taxable income by as much as $24,400, depending on filing status. For many Americans, this can mean bumping down an entire tax bracket and/or reducing their tax burden by thousands of dollars.
If it saves you even more money, you can opt for an itemized deduction instead. Itemizing deductions allow you to calculate your exact eligible expenses throughout the tax year; if the total is more than the standard deduction, itemizing can mean saving even more money.
Other common tax deductions include student loan interest and mortgage interest deductions, as well as certain self-employment expenses, state sales tax, and education costs.
Read more: The Most Common Tax Deductions
Common Tax Credits
The most common tax credits include the Child and Dependent Care Credit (up to $6,000) and the EITC, or Earned Income Tax Credit (up to $6,557 in 2019). Remember, these reduce your tax burden dollar-for-dollar, so you don’t want to miss out on any credits for which you’re eligible.
Other common tax credits include the Lifetime Learning Credit, the American Opportunity Tax Credit, adoption credits, saver’s credits, and energy-efficient property credits.
Refundable vs Nonrefundable
Tax credits can be either refundable or nonrefundable.
If they are refundable, you will get the money back no matter what, even if you don’t actually owe anything in taxes. This means that if you have a $0 tax burden before applying a $500 credit, you will actually get a $500 refund. Already expecting a $245 refund? That now jumps up to $745.
Nonrefundable credits, however, aren’t quite as fun.
If you have a $500 tax burden and then apply a $500 nonrefundable tax credit, your IRS bill goes down to zero. If you have a $100 tax burden before applying that nonrefundable credit, however, your bill will still go to zero — you won’t get the remaining $400 back in the form of a refund.
Some of these credits will carry over to future years, so you can still take advantage of every penny you’re due. Others, however, do not allow for carryover, so the additional savings are simply lost.
Which is Better?
Comparing apples to apples, tax credits are definitely more valuable than tax deductions of the same value. Deductions only reduce your taxable income, so you’re really just saving a percentage of that deduction off your taxes. Credits, on the other hand, are dollar-for-dollar savings.
With that said, both are very valuable. You should be sure to include every single credit and deduction for which you’re eligible when it comes to filing your taxes. Plus, the most common deductions offered are pretty high in value, meaning that they can still significantly reduce your tax bill once applied.
If you are unsure of which credits and deductions you’re able to take, many online tax filing services make it easy. You can always hire a CPA, too, if you want a personal touch (and maximum savings) come tax time.
Here’s a look at the 7 best tax software options available:
|Software||Federal eFile Cost||Best For|
|TurboTax||$0 to $150||Those who want extra guidance and advice while filing, along with an easy-to-use interface.|
|H&R Block||$0 to $139.99||Those at a higher risk of being audited, since they offer free in-person audit support.|
|TaxAct||$0 to $74.95||Those who want to save money but still need some guidance on taxes.|
|TaxSlayer||$0 to $47||Those who are confident in filing their taxes and want to save as much as possible.|
|FreeTaxUSA||$0 to $6.99||Those who want to save money when filing taxes more than anything else.|
|eSmart Tax||$44.95 - $89.95||Those who want to save but also have the security and backing of a trusted company.|
|e-File||$0 to $34.95||Those who have more complex tax situations but still want to save money.|